Often, I’ll see commercials being played which tout the past performance of an Exchange Traded Fund (ETF), or group of ETFs, insinuating that buying into said ETFs will somehow provide outperformance in the future.
This sort of mentality boggles my mind, and in this article, I’m going to explain why such an investing mentality is bound to turn out poorly for any investor interested in engaging in such strategies long-term.
First of all, before I get into the meat of my argument, I should point out that momentum investing is indeed a strategy that has paid off, in particular sectors and with particular companies, in recent years.
Buying what was hot, and expecting said company to continue to be hot in the future, is a strategy best employed when the market is in a frenzy (we’re now in one of the longest bull markets in history), or when the market is melting up, which it is now.
That being said, there is an economics and finance term for why investing in the darling of yesteryear is a bad idea - reversion toward the mean. What mean reversion essentially means is that companies will tend to grow at a certain long-term rate over time; when the growth rate of a company goes too high or low, at a given point in time, a reversion toward a longer term growth rate is likely.
For example, if company A averages 10% growth in earnings and revenues every year, investors who see performances of 10%, 10%, 10%, 10%, 50% over the past five years will note just how out of whack the market can get at times, and should expect a pullback in such a scenario, to get the company (or ETF for that matter) down toward the long-term average growth rate.
Invest wisely, my friends.
